Yesterday, Chairman Hatch (R-Utah) released a modified mark of the Senate tax reform proposal. The modified mark makes significant changes to the original proposal, including providing for the sunset of many of the tax cuts for individuals after December 31, 2025 and modifying the application of the pass-through and international rules.
The revised proposal would eliminate the Affordable Care Act’s individual mandate. “By scrapping this unpopular tax from an unworkable law, we not only ease the financial burdens already associated with the mandate, but also generate additional revenue to provide more tax relief to these individuals,” Hatch said in a statement.
A score of the modified mark provided by the Joint Committee on Taxation indicates that the modified proposal complies with budget requirements to pass via reconciliation. However, an analysis by the Congressional Budget Office suggests that, if the proposal were enacted in fiscal year 2018 without enacting any further legislation to offset the deficit increase, the Pay-As-You-Go Act of 2010 (PAYGO) would require the Office of Management and Budget to issue a sequestration order.
Major provisions of the modified mark include:
- Repeal of the Individual Mandate
- Under the Chairman’s modification, individuals would not be subject to a tax for failure to maintain health coverage under the Affordable Care Act.
- Expiration of Title I
- The Chairman’s modification adds an expiration date of December 31, 2025 to all proposals contained in Title I of the original Chairman’s mark. This does not apply to the proposal that requires the use of the chained CPI-U to index tax parameters currently indexed by the CPI-U.
- Individual Tax Rates
- The Chairman’s modification adjusts the individual tax brackets to 12%, 22%, 24%, 32%, 35%, and 38.5%.
- Child Tax Credit
- The child tax credit is increased to $2,000 and modifies the threshold amount where the credit begins to phase out to $500,000 for married taxpayers filing a joint return.
- Estate Tax
- The Chairman’s modification retains the doubled estate, gift, and generation-skipping tax exemptions until December 31, 2025. However, those exemptions revert back to $5 million (indexed for inflation) after December 31, 2025.
BUSINESSES - GENERAL
- Pass-through Rate
- The Chairman’s modifications would automatically sunset the 17.4% deduction for domestic qualified business income after December 31, 2025.
- Additionally, the Chairman’s modifications would significantly expand the originally-proposed 17.4% deduction in the following two ways:
- The Senate proposal initially limited the 17.4% deduction of domestic qualified business income of an individual to 50% of W-2 wages allocable to such individual from pass-through entities or sole proprietorships starting from the first dollar of domestic qualified business income. The Chairman’s modifications would fully turn off such limit to the extent the individual has taxable income less than or equal to $500,000 (if married filing jointly). The W-2 wage limit would then be phased in over the next $100,000 of taxable income for married individuals filing jointly.
- The Chairman’s modification provides that the exception allowing the 17.4% deduction in the case of certain taxpayers with income from a specified service business applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly (rather than $150,000 under the initial proposal). The benefit of the deduction for specified service businesses would be phased out over the next $100,000 of taxable income for married individuals filing jointly. This specific expansion opens up the ability of many higher-income business-owner professionals to claim the deduction.
- The Chairman’s modification also makes two changes to the treatment of electing small business trusts (ESBTs):
- An ESBT may be a shareholder of an S corporation. Currently, the eligible beneficiaries of an ESBT include individuals, estates, and certain charitable organizations eligible to hold S corporation stock directly; a nonresident alien individual may not be a potential current beneficiary of an ESBT. The proposal would allow a nonresident alien individual to be a potential current beneficiary of an ESBT.
- Currently, because an ESBT is a trust, the deduction for charitable contributions applicable to trusts, rather than the deduction applicable to individuals, applies to an ESBT. The proposal provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. “Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.”
- International Provisions
- Modified Proposals
- Modification to deduction for global intangible low-taxed income. The Chairman’s modification reduces the proposal’s deduction for global intangible low-taxed income (GILTI) from 50% to 37.5% for taxable years beginning after December 31, 2025. For taxable years beginning after December 31, 2017, and before January 1, 2026, the proposal’s 50% deduction for GILTI is unchanged.
- Modification to deduction for foreign-derived intangible income. The Chairman’s modification reduces the proposal’s deduction for foreign-derived intangible income from 37.5% to 21.875% for taxable years beginning after December 31, 2025. For taxable years beginning after December 31, 2017, and before January 1, 2026, the proposal’s 37.5% deduction for foreign-derived intangible income is unchanged.
- Election with respect to NOLs and the treatment of deferred foreign income upon transition to participation exemption system. The Chairman’s modification allows taxpayers to elect to preserve net operating losses (NOLs) and opt out of utilizing such NOLs to offset the mandatory inclusion required of a U.S. shareholder under the transition proposal. In addition, the modification provides rules to coordinate the interaction of existing NOLs, overall domestic losses, and foreign tax carryforward rules with the income inclusions required under section 965.
- Clarification that qualified deficits are permitted to offset transition earnings. The Chairman’s modification clarifies that the mandatory inclusion required of a U.S. shareholder under the transition rule is generally reduced by the foreign earnings and profits (E&P) deficits, including qualified deficits.
- Modification to tax on base erosion payments with substantial gross receipts. The Chairman’s modification changes the proposal’s tax rate of 10% to a rate of 12.5% of the modified taxable income of the taxpayer for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year for taxable years beginning after December 31, 2025. The Chairman’s modification also excludes an amount paid or incurred for services if those services meet the requirements for the services cost method under section 482 (with certain exclusions) and if such amount is the total services cost with no markup, for taxable years beginning after December 31, 2017.
- New Proposals
- Modification to source rules involving possessions. The proposal modifies the sourcing rule in section 937(b)(2) by modifying the U.S. income limitation to exclude only U.S. source (or effectively connected) income attributable to a U.S. office or fixed place of business. The proposal also modifies section 865(j)(3) by providing that capital gains income earned by a U.S. Virgin Islands resident shall be deemed to constitute U.S. Virgin Islands source income regardless of the tax rate imposed by the U.S. Virgin Islands government. The proposal is effective for taxable years beginning after December 31, 2018.
- Repeal exclusion applicable to certain passenger aircraft operated by a foreign corporation. The proposal modifies the reciprocal exemption from U.S. tax under section 883(a)(2) for gross income derived by a foreign corporation from the international operation of an aircraft by adding two additional requirements. Under the proposal, the exemption shall not apply if (1) the foreign corporation engaged in the international operation of an aircraft is headquartered in a foreign country without an income tax treaty between the United States and such foreign country, and (2) the foreign country has fewer than two arrivals and departures (per week) from major passenger airline carriers headquartered in the United States. The proposal is effective for taxable years beginning after December 31, 2017.
- Modified Proposals
- Business Deductions
- R&D Expenditures. The Chairman’s modification adds a new provision requiring amortization of research and experimentation expenditures incurred after December 31, 2025. The provision, like the House proposal, would require amounts defined as specified research or experimental expenditures to be capitalized and amortized ratably over a five-year period (15 years for specified foreign expenditures). Amounts paid or incurred in connection with the development of software shall be treated as a research or experimental expenditure and must also be amortized. If property with respect to which research or experimental expenditures are paid is disposed, retired, or abandoned during the amortization period, the amortization deduction shall continue notwithstanding that disposition.
- Expensing. The Chairman’s modification expands the definition of qualified property eligible for the additional first-year depreciation allowance to include qualified film, television and live theatrical productions, effective for productions placed in service after September 27, 2017, and before January 1, 2023.
- Recovery Period for Real Property. The Chairman’s modification shortens the alternative depreciation system recovery period for residential rental property from 40 years to 30 years, effective for property placed in service after December 31, 2017.
- Net Operating Losses. The Chairman’s modification limits the net operating loss deduction to 80% of taxable income (determined without regard to the deduction) in taxable years beginning after December 31, 2023.
COMPENSATION AND RETIREMENT SAVINGS
- Deferred Compensation
- With respect to deferred compensation, the Chairman’s modification:
- Eliminates the provisions that would repeal section 409A governing deferred compensation.
- Eliminates the provisions that would repeal the special deferred compensation rules for executives of tax-exempt organizations under section 457(f) and 457(b) and the rules applicable to tax indifferent entities under section 457A.
- Adds a new election, similar to a section 83(b) election, that would alter the income inclusion timing rules applicable to stock related to stock options and stock-settled restricted stock units granted to certain employees of a non-public company under a broad-based equity compensation plan. The proposal would require the plan to cover at least 80% of employees in the controlled group, and contains numerous other conditions and requirement. A similar proposal was included in H.R. 1 as a new section 83(i).
- With respect to deferred compensation, the Chairman’s modification:
- $1 Million Deduction Cap
- The Chairman’s modification retains the original mark’s changes to the $1 million deduction cap on public company executive compensation under section 162(m), and adds a transition rule under which such changes would not apply to remuneration subject to a written binding contract entered into before November 17, 2017 (and not thereafter modified), and vested by December 31, 2016. The proposed changes include commissions and performance-based compensation in the calculation of the $1 million cap, thereby discouraging excess compensation, and changes the executives to whom section 162(m) applies. Under current law, section 162(m) provides for the exclusion of commissions and performance-based compensation from the $1 million cap.
- Excise Tax on Tax Exempt Organizations for Excessive Compensation
- The Chairman’s modification does not change the original mark’s 20% excise tax on tax-exempt organizations for paying compensation to certain highly compensated employees in excess of $1 million, such as coaches at public colleges and universities, and does not change the provisions adding a new 20% excise tax similar to the “parachute tax” under section 280G which would apply to a tax-exempt organization that pays certain executives excess amounts that are contingent upon a separation from employment, rather than upon a change in control.
- Worker Classification
- The Chairman’s modification eliminates the prior proposal on change to the current worker classification rules.
- Retirement Savings
- The Chairman’s modification deletes the provision that would have applied a 10% early withdrawal tax to early distributions (before age 59½) from a governmental section 457(b) plan.
- The Chairman’s modification deletes the provision that would have eliminated catch-up contributions for high wage earners.
- The Chairman’s modification retains provisions which would coordinate the limits for governmental section 457(b) plans with the limits for section 401(k) and 403(b) plans so that the same limits apply to elective deferrals and catch-up contributions under section 401(k) plans, section 403(b) plans and governmental section 457(b) plans. This provision would also revise application of the limit on aggregate contributions so that a single aggregate limit applies to contributions for an employee to any defined contribution plan, section 403(b) plan, and any governmental section 457(b) plan maintained by the same employer.
- The Chairman’s modification retains provisions that would repeal the special rules allowing additional elective deferrals and catch-up contributions under section 403(b) plans and governmental section 457(b) plans, and that would repeal the special rule allowing employer contributions to section 403(b) plans for up to five years after termination of employment.
- The Chairman’s modification adds a provision from the original House bill that would repeal a special rule that allows an individual to re-characterize a contribution to a traditional IRA as a contribution to a Roth IRA (and vice versa). The change is intended to prevent taxpayer abuses that can result from manipulating such conversions.
- The Chairman’s modification adds a provision from the original House bill that would extend the period of time during which a qualified plan loan offset amount may be contributed to an eligible retirement plan as a rollover contribution in the event the employee separates from service, or the plan terminates, while a loan is outstanding.
- The Chairman’s modification provides relief for individuals in the event of a wrongful IRS levy against an IRA or employer-sponsored plan, such as a levy that was not in accordance with IRS administrative procedures. If the amount that was distributed from the IRA plan to satisfy the levy is returned to the individual by the IRS, the proposal would allow the individual to contribute the returned amount with interest to an IRA or employer-sponsored plan.
- The Chairman’s modification provides a special exception to the 10% early withdrawal tax in the case of a qualified Mississippi River Delta flooding distribution from a qualified retirement plan, a section 403(b) plan or an IRA.
- Consistent with the original Senate mark, the Chairman’s modification makes no mention of subjecting governmental pension plans and other entities to the unrelated business income tax (UBIT) rules as the House bill did.
- The Chairman’s modification would generally sunset the provisions of Title I of the bill, covering tax reform for individuals. As a result:
- The changes in the standard deduction, itemized deductions, individual marginal rates, and the estate tax (which generally would weaken the tax incentive to make charitable contributions) would no longer apply after December 31, 2025.
- A provision that would increase the percentage-of-income limitation for cash contributions from 50% to 60% would no longer apply after December 31, 2025.
- The Chairman’s modification adopts two provisions relating to tax-exempt organizations from the House bill that were omitted from the original Senate proposal:
- The repeal of the controversial option in section 170(f)(8)(D) under which the IRS currently may allow donee organizations to report charitable contributions to the IRS instead of sending a contemporaneous acknowledgement to the donor.
- A limited exception to the excess business holding rules for private foundations that would be created for certain wholly-owned and independently operated businesses where all net operating income promptly is distributed for use in the foundation’s charitable purposes.
- The Chairman’s modification allows for the designation of certain low-income community population census tracts as qualified opportunity zones, and provides tax incentives to encourage investment in qualified opportunity zones through qualified opportunity funds that are certified by the Department of Treasury’s Community Development Financial Institutions Fund in a manner similar to the process for allocating the new markets tax credit.